FAQ's>>BASICS OF DERIVATIVES

What are derivative instruments?
A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stock indices, etc. Derivative instruments in stock exchanges are Index Futures, Stock Futures, Options on Index and Options on Individual Stocks. At present on NSE, different Index Futures are: Nifty Future, Bank Nifty Future, and CNX IT Future, and different Index Options are: Option on Nifty, Option on Bank Nifty and Option on CNXIT. Besides these, stock futures on specified individual stocks on NSE and Stock Options on those specified stocks on NSE are allowed to trade.

What are Forward contracts?
A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are:(a) They are bilateral contracts and hence exposed to counter party risk.(b) Each contract is custom designed, and hence is unique interims of contract size, expiration date and the asset type and quality.(c) The contract price is generally not available in public domain.(d) The contract has to be settled by delivery of the asset on expiration date.(e) In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

What are Futures?
Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the buyer and the seller. Today the contracts have certain standardized specifications. Futures traded by stock exchanges are Index Futures and Stock Futures.

What is the difference between Forward contracts and Futures contracts?
Futures are a type of forward contract. The following are the main differences between the two.

1. Standardized v. Customized Contract: The terms of a Forward Contracts are individually agreed upon between two counterparties, while Futures being traded on exchanges have terms standardized by the exchange. Forward contract is customized and Future is standardized.
2. Counter party risk: In case of Futures, after a trade is confirmed by two members of the exchange, the exchange/clearing house itself becomes the counter-party (or guarantees) to every trade. The credit risk, which in case of forward contracts was on the counter-party, gets transferred to exchange/clearing house, reducing the risk to almost nil.
3. Liquidity:Futures contracts are much more liquid and their price is much more transparent due to standardization and market reporting of volumes and price.

A forward contract can be reversed only with the same counter-party with whom it was entered into. A Future
contract can be reversed with any member of the exchange